Econ - Micro - Moral hazard introduction

Moral hazard definition

A situation that arises when one party in an economic transaction cannot observe the other party's behaviour

What is the result of moral hazard?

After the contract has been agreed, the agent may have an incentive to lie about the action in a way that is detrimental to the principal

What are the 4 stages in the moral hazard cycle?

1. Principal contracts agent 2. Agent performs action - principal does not see - agent prefers different action to principal - and can lie 3. Outcome depends on action of agent and state of the world (neither observable to principal) 4. If action is wrong for principal - lower expected payoff

3 conditions for moral hazard to occur

1. There is some conflict in interests between agent and principal - in relation to action/behaviour 2. The action is unobservable 3. There is uncertainty for principal about the environment in which action/behaviour takes place - 'state of the world'

What is the solution to advert moral hazard?

The principal can alter the structure of the contract as to influence the incentives faced by the agent